Question

Problem 11 section 13.2)

(The Allais Paradox) Suppose we are offered a choice between the following two lotteries:

L1: With probability 1, we receive $1 million.

L2: With probability .10, we receive $5 million.

: With probability .89, we receive $1 million.

: With probability .01, we receive $0.

Which lottery do we prefer?

Now consider the following two lotteries:

L3: With probability .11, we receive $1 million.

: With probability .89, we receive $0.

L4: With probability .10, we receive $5 million.

With probability .90, we receive $0.

Which lottery do we prefer? Suppose (like most people), we prefer L1 to L2. Show that L3 must have a larger expected utility than L4.

1. Read Problem #11 at the end of Section 13.2. Show that if a decision maker says she (strictly) prefers L₁ to L₂ and she also prefers L₄ to L₃, she cannot be an expected utility maximizer.

Answer 1